The FDR Framework is the backbone for a 21st century financial system. Under this framework, governments ensure that every market participant has access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to analyze this data because they are responsible for all gains and losses.

Friday, November 2, 2012

Banks suffering credibility discount

In his Telegraph column, Damian Reece argues that if only the banks had been given a bigger bailout they would be supporting the real economy.

Regular readers know that the problem was that banks were given any bailout in the first place. As Iceland has shown, the necessary first step for ending the financial crisis is to require the banks to recognize all the losses on their bad debt exposures upfront.

This action saves the real economy because the real economy is not subject to diverting capital that is needed for reinvestment and growth to paying the debt service on the excess debt.

On the other hand, bailing out the banks puts the debt service burden of the excess debt on the real economy with the result that the real economy goes into a Japanese-style slump.

However, that still leaves another very wide gap and that’s the distance between what Barclays claims its shares are worth and what the market believes they’re worth. In terms of credibility, it’s a discount every bit as serious as the bank’s reputation gap.

The one value Barclays, and every other bank, assigns to its share price is a net asset value per share, which in the case of Barclays is 444p. However, the stock market assigns a value of just 227.5p a share – a near 50pc discount.

In simple terms the market doesn’t believe the value of the bank’s assets and therefore their profitability.

If Barclays' assets are really worth only half the value it claims, then they should be written down, which would result in huge losses that would threaten its solvency and require another massive capital injection.

Barclays is not alone. All our banks are suffering the same credibility discount when it comes to their finances and are trading on similar valuations.

Under all circumstances, the banks should be required to provide ultra transparency and disclose on an ongoing basis their current global asset, liability and off-balance sheet exposure details.

If the banks are right, this disclosure will result in their share price increasing.

If the market is right, this disclosure will result in the the banks recognizing upfront the losses on its bad debt.

It’s why many voices, including influential regulators, are calling on banks to raise yet more capital, especially as the eurozone crisis shows no sign of abating and economic recovery is weak.

But the reason banks aren’t seeking more funding is because, within the present regulations and accounting standards, they can exist without it.

We’re walking a tightrope over a cavern of troubles in the hope banks make it to the other side. Once there, when conditions have normalised, they can be recapitalised at a sustainable and prudent level.

This is a statement of the hoped for outcome should the Japanese Model of protecting bank book capital levels and banker bonuses be successful.

Forcing them to do it now would be futile because investors are in no mood to write the cheques, governments certainly won’t do it and insisting that capital is replenished from lenders’ own resources would result in even less lending than now.

Mr. Reece makes an interesting observation about bank capital.

Clearly, the market will not provide additional capital. This is the result of banks being 'black boxes' and nobody knows what is inside the box.

What’s probably true is that the original bank bail-outs were inadequate. Arguably, a better use of the public funds which have been used to pump prime growth would have been to fund a much bigger bail-out of the banks. This would have been unpopular but we would now have lenders looking far less zombified and much more capable of financing economic recovery.

Actually, what is true is that adopting the Swedish Model and requiring the banks to recognize all the losses on their bad debt upfront would be better. With the bad debt behind them, banks could then make loans to support economic recovery.

As it is we’re struggling with the consequences of half-baked bank bail-outs and half-baked fiscal programmes struggling to deliver an effective antidote to fully-baked austerity and economic torpor.

The easy way out of this torpor is to stop protecting bank capital levels and require the banks to recognize the losses on their bad debt upfront.

About this blog

A blog on all things about Wall Street, global finance and any attempt to regulate it. In short, the future of banking and the global financial system.

This blog will be used to discuss and debate issues not just for specialists, but for anyone who cares about creating good policies in these areas.

At the heart of this blog is the FDR Framework which uses 21st century information technology to combine a philosophy of disclosure with the practice of caveat emptor (buyer beware).

Under the FDR Framework, governments are responsible for ensuring that all market participants have access to all the useful, relevant information in an appropriate, timely manner. Market participants have an incentive to use this data because under caveat emptor they are responsible for all gains and losses on their investments; in short, Trust but Verify.

This blog uses the FDR Framework to explain the cause of the financial crisis and to evaluate financial reforms like the ABS Data Warehouse.